DARK POOLS

High-Speed Traders, A.I. Bandits and the Threat to the Global Financial System

By Scott Patterson, freelance writer and staff reporter for The Wall Street Journal

A news-breaking account of the global stock market’s subterranean
battles, Dark Pools portrays the rise of the “bots”– artificially
intelligent systems that execute trades in milliseconds and use the
cover of darkness to out-maneuver the humans who’ve created them.

Haim Bodek, one of the key figures of Dark Pools, is profiled today in a page one The Wall Street Journal article (written by me and my colleague, Jenny Strasburg). The story dives deeper into Bodek’s odyssey at the high-frequency firm he helped run, Trading Machines, and reveals more about his role in a sweeping SEC probe into ties between stock exchanges and some computer-driven funds.

The story also reveals more of the inner workings of an “order type” that Bodek learned about at Trading Machines, one he came to believe gave HFTs the ability to step in front of other investors’ orders. It’s name: Hide Not Slide, provided by Direct Edge. (For more on Direct Edge’s order types, read the following.)

By now everyone has heard about Knight Capital Group’s $440 million trading loss on August 1. The loss is devastating for Knight and its employees, who may soon find themselves out of work–or working for a new boss. Defenders of the status quo would like to point out that the only victim here is Knight and that the rest of the market worked just fine on August 1. In other words, nothing to see here, move along.

The truth is, Knight is possibly a more frightening red flag of dangers in the market than the notorious Flash Crash of May 6, 2010. Knight is a massive broker dealer that sat at the heart of the stock market. On many days it accounts for more trading on the New York Stock Exchange and Nasdaq than any other firm in the world. What’s more, Knight’s trading debacle shows that other brokers dealers–Too Big to Fail giants we’ve all come to know and love–are also at risk. Giant banks–all of them–have high-speed trading operations inside their walls, operations exactly like the one that erased nearly half a billion of Knight’s capital in a little more than 30 minutes.

Here’s the question: What would happen if such a “glitch” ate a hole in the balance sheet of a TBTF bank? Now we’re talking something else. Systemic risk–and tax payer bailouts. Again.

I used to listen to Brian Lehrer whenever I had to chance when I lived in New York City. He’s one of the best there is in radio. This morning I had the honor of speaking with him about Dark Pools live from NPR’s headquarters in Washington, D.C. I explained that the market has transformed into a computer-driven trading machine so rapidly that regulators have been lapped–and lapped again. We talked about the Flash Crash–and the Splash Crash. Check it out here.

I recently conducted a Q&A with Mark Cuban about his thoughts on computer trading for The Wall Street Journal Online. Cuban makes some very interesting observations about the current state of the markets, calling high-frequency traders the “ultimate hackers.”

More importantly, his thoughts about the role of exchanges in the economy are especially prescient given the wave of troubles we’ve seen recently, including the bungled Facebook IPO and the failed BATS Global Markets IPO. “Is the market supposed to be a platform for companies to raise money for growth and to create liquidity and opportunity for shareholders as it has been in the past?” he asks. “Or is the stock market a laissez-faire platform that evolves however it evolves? The missing link in all the discussions is: What is the purpose of the stock market?”

Good questions, and issues that are at the core of my new book Dark Pools. WSJ.com will be running a follow-up Q&A I conducted with another close observer of the fascinating subject of computer trading soon. Stay tuned.

One of the primary themes in my new book Dark Pools is embedded in the title–the market is dark. It’s dark to regular investors, to institutional traders, to fund managers, to exchange operators, and to regulators. There are many reasons for this, but primarily it is due to the massive number of orders flooding the system from high-frequency firms and the complexity of how those orders interact with other orders inside exchanges and dark pools. Essentially, the market has become too complex, and too fast, for the human mind to follow or even remotely understand.

That’s a problem–a big problem. Because retail investors are starting to realize that no one is watching. Even Mary Schapiro, chairman of the SEC, has told Congress that her agency doesn’t have the ability to track what’s going on in the stock market (and just forget options). So who can know? Who can reassure the investing public that the market, despite many signs to the contrary, really isn’t rigged?

No one can.

The SEC has proposed building a computer system to track the market, the consolidated audit trail, which I wrote about for The Wall Street Journal last September. But there’s been little word of progress on the so-called CAT. Until there is, investors are going to remain in the dark.

The Commodity Futures Trading Commission is trying to hammer out a definition for high-frequency trading, which I wrote about for The Wall Street Journal this Wednesday. It’s a tough job for the commission, because few outsiders truly understand how high-frequency firms operate.

Indeed, there are few people in the world–if any–who can authoritatively say how these firms trade en masse. While employees at one firm may have a strong understanding of how they operate, they can have little idea how the dozens of HFTs they’re competing against trade. Even exchange operators can’t know fully what’s going on, because the trades are dispersed across dozens of markets.

I commend the CFTC for what it’s doing. I needs to be done. But it’s not going to be easy. Because it’s a dark market.

This morning I walked onto the floor of the New York Stock Exchange for an interview on CNBC about Dark Pools. As I stood their waiting for the interview, I looked around–and was astonished. It was about 10 minutes after the opening bell, and the mood of the floor was…an eery calm. Market makers and traders were chit-chatting, laughing, standing around. It was nothing like the manic floor of old. And by old, I mean five years ago.

It’s amazing. There are only four “designated market makers” today (DMMs replaced the specialists). They are Getco, Barclays, Goldman Sachs, and Knight–all expert firms in computer trading. Ten years ago, there were 35 specialist firms on the floor of the Big Board.

Dark Pools was finally released to the world today–find it at your local bookstore or buy it on Amazon. To mark the launch I awoke early in downtown Washington, D.C., and walked to the local Marketplace radio studio for an interview. How the robots ate your stock market…

An excerpt from Dark Pools is in The Wall Street Journal today. It gives a brief glimpse into a chapter about the Flash Crash of May 10, 2010, when a series of computer glitches in trading systems across the country caused the market to fall 10% in a matter of minutes.

The Flash Crash is only part of the story told in Dark Pools. The book also explains where it all came from–the millisecond trading machines, the AI-armed computer algos that can shift and learn how to trade on the fly. It all began with a tiny firm called The Island and a computer programming genius called Josh Levine. Levine and his small team of renegade programmers created a revolutionary trading platform that launched the high-frequency trading paradigm that now dominates stock trading in the U.S.

Levine’s dream was to open up the market and make it cheaper and easier for regular investors to use. But something went wrong along the way. In recent years, powerful high-speed trading firms became one of the primary sources of revenue for the exchanges. They delivered huge volumes to the exchanges with their rapid-fire trading systems. The exchanges began to compete for their services, providing benefits for those firms that could deliver the most volume.

The trouble: Other firms using the exchanges–think the mutual fund in charge of your retirement–didn’t get the same benefits.

In little more than a decade, one of the most unpredictable, emotion-wracked corners of the global economy–the United States stock market–has become captured by giant machines run by highly complex artificial intelligence systems.

It will make news. It will make people angry. It will incite controversy. And it will, no doubt, be attacked by the very people whose livelihoods depend on the status quo.

Which is ironic. That’s because, as I show in Dark Pools, these people–the new cyber-kings of the market–were the very same game changers who took down the previous privileged elite, the Nasdaq market makers, the New York Stock Exchange specialists, the powerful broker dealers at the giant banks, all the while championing a level playing field. The truth is, they’ve made the playing field anything but level.

The history of that transformation–and a chilling look at a possible future in which the human element of the market is forever erased–is told in the pages of Dark Pools. Stay tuned.

Praise for THE QUANTS

“Scott Patterson has the ability to see things you and I don’t notice. In The Quants he does an admirable job of debunking the myths of black box traders and provides a very entertaining narrative in the process.”

—Nassim Nicholas Taleb, New York Times bestselling author of FOOLED BY RANDOMNESS and THE BLACK SWAN